6.2 / 23 - Allocation to Commodities

Question 1

LO 23.1: Demonstrate knowledge of the five beneficial characteristics of allocations to commodity futures

Answer 1

• List the five beneficial characteristics for investors when allocating to commodity futures. • Describe the effects of full collateralization on commodity risk, diversifying a traditional portfolio with commodity futures, and adding commodities exposure in an asset-liability management investment setting. • Describe the hedging benefits of commodity futures over time and in various economic cycles. • Discuss the performance of commodities in each of the four major business cycle phases. • Explain how mean reversion can be a great benefit of commodity investment. • Understand why commodity investment may be well suited to capture diversification return. • Explain why volatility reduction enhances geometric mean returns, but does not enhance expected values in commodity investing. • Discuss the source of positive risk premium of commodity investments and the effect of this positive risk premium on investment decisions. • Discuss the source of positive skewness of commodity investments and the effect of this positive skewness on investment decisions.

Question 2

Five beneficial characteristics of allocations to Commodity Futures

Answer 2

• Ability to hedge inflation, business cycle, and event risk. • Improved risk and return profiles of portfolios due to commodity futures’ low correlation with stocks and bonds. • Improved performance through rebalancing a portfolio called the diversification return due to commodity prices exhibiting mean reversion. • Potential for a positive risk premium and roll return. • Positively skewed return distributions.

Question 3

Diversification benefits of Commodities Futures

Answer 3

• Greater than with spot market; captures the convenience yield. - Better than owning stocks of commodity-based firms for diversification purposes. - Superior div’n and liquidity benefits relative to other alts such as real estate. - Correlation between comm and equities&bonds are negative, become more negative around the 5 year time horizon. - Studies indicate that over time, correlation between S&P GSCI and Global stocks is increasing, making div’n benefits decrease over time.

Question 4

FINANCIALIZATION OF COMMODITY MARKETS

Answer 4

• resulte of money flowing into commodities, becoming more more integrated into theinvestment universe. Increases correlation to the financial markets.

Question 5

Commodities Futures as an inflation hedge

Answer 5

Inflation rate is positively correlated to an equally wieghted portfolio of commodity futures prices at all time horizons, even more so for longer horizons. - vs. stocks which is negatively correlated to inflation in long term, and bonds which is negatively correlated in short term. - Comm Indices are very useful for heding inflation - individual comm’s vary in usefulness for this. -Precious Metals, Industrial metals, and energy products can be good inflation hedges

Question 6

Business Cycle Diversification

Answer 6

• Works different than STocks throughout the business cycle, provide good diversification against systematic risk

Question 7

event risk

Answer 7

exposure to signficant events that have potential to cause large negative returns for stocks. - commodities generally have positive exposure to events , creating low or negative correlation with traditional assets. (tend to benefit from unexpected events). -

Question 8

Mean reversion

Answer 8

the tendency for an asset’s price to return to its long running average value. Commodities have this. -

Question 9

DIVERSIFICATION RETURN

Answer 9

Effect of Rebalancing a portfolio of commodities that exhibit mean reversion back to its original target asset allocation will result in an increased average or geometric mean return. Result of two factors: 1) Reducing the allocation to assets that have increased in value back to their target weight capturing their positive returns. When they mean revert, the impact of their negative returns on the portfolio will be lessened due to their reduced weight in the portfolio. 2) Increasing the allocation to assets that have decreased in value back to their target weight resulting in an increased return to the portfolio when they mean revert and increase in value.

Question 10

What two properties allow Commodities to have Diversification Return

Answer 10

(1) low correlation between volatile assets in a portfolio, and (2) individual asset prices exhibit mean reversion.

Question 11

Commodity Skewness and Kurtosis

Answer 11

• Commodities have positive exposure to less predictable events, which positively skews their return distribution. It is not present in all time periods however. - Commodities are associated with higher kurtosis (Fat tails) than trad investments.

Question 12

LO 23.2: Demonstrate knowledge of commodity investment strategies.

Answer 12

• Discuss the unique risk and return characteristics of commodities, as compared to traditional investments.

Question 13

LO 23.3: Demonstrate knowledge of directional strategies.

Answer 13

• Describe directional strategies in commodities markets

Question 14

DIRECTIONAL COMMODITY sTRATEGIES

Answer 14

Based on a forecast of the direction of the market, and are exposed to systematic risk - generally establish long or short positions in commodity derivatives (listed futures, options, OTC forwards and swaps) based on forecasts of comm price changes. - 2 groups - Fundamental Directional Strategies, and Quantitative Directional Strategies

Question 15

Fundamental directional strategies (1 of 2 Directional Commodities Strategies)

Answer 15

• use supply and demand analysis as well as fundamental macro factor analysis (interest rates, econ growth, currencies, industry factors) to determine the direction of commodity Prices

Question 16

Quantitative Directional Strategies (2 of 2 Directional Commodities Strategies)

Answer 16

• identify undervalued or overvalued commodities using technical and quant indications (moving average systems) - often focus on roll yield, conveninece yield, and risk premium

Question 17

LO 23.4: Demonstrate knowledge of relative value strategies

Answer 17

• Describe relative strategies in commodities market

Question 18

Relative value strategies

Answer 18

based on identifying mispriced assets and hedging their market exposure - use sector-specific expertise of fund manager to trade the relative price difference betwen commodities based on one or more risk dimensions. Three of the risk dimensions: 1. Location. A single commodity can have different prices in different markets. 2. Correlation. Two commodities may diverge from their historical price correlation. 3. Time. A single commodity can have different prices for different delivery times.

Question 19

LO 23.5: Demonstrate knowledge of commodity futures and options spreads.

Answer 19

• Describe various types of calendar spreads, and calculate the position profit and loss for a commodity spread trade. • Describe processing spreads, including typical users and common types. • Describe substitution commodity spreads, two major types of substitutions in commodities, and how to determine entry and exit points with a substitution test statistic. • Describe quality and location spreads, and how they differ from substitution spreads. • Describe intermarket relative value strategies

Question 20

Commodity spread strategies

Answer 20

• refer to trading strategies that capitalize on the relative mispricing of two or more commodity-related invesstments. - Sub-strategies include calendar spreads, processing spreads, substitution spreads, quality spreads, location spreads, and intramarket relative value. - For a commodity spread trade, two positions are opened at the same time and later closed at the same time. Thus, there are four transactions in total.

Question 21

P&L Calculation for Spread Trade (Table for reference)

Answer 21

Question 22

Commodity Time Spreads

Answer 22

exploit trading opportunities among commodity derivatives including futures, forwards, swaps, and options across the time dimension.

Question 23

Calendar Spread

Answer 23

• Most basic time spread, involves taking long and short futures positions for different delivery times and can be customized to provide liquidity or insurance
• • Liquidity trade - eg taking a long position in a futures contract for delivery in a specific month, taking a short position in a futures contract with a slightly longer maturity. Trade absorbes excess short contracts in the market (provides liquidity) through the shorter term contract, offsets the position through the longer contract with expectation that prices will rise, and generate a profit
• • Insraunce trade - eg taking a short position in March natural gas futures contracts and offseeting long position in April contracts will be profitable in a mild winter (warm weather will push the price for March delivery below the trader’s contract selling price, generating a profit) - could suffer signficant losses if harsh winter though.
    
    • This is related to selling a synthetic weather derivative (i.e., insurance against a harsh winter)

Question 24

Calendar Spreads (Bull vs Bear)

Answer 24

• bull spread - this takes long futures positions in a short term contract and short position in longer term contract - in contangoed [vs. backwardated] markets, the trade is profitable if the spread between the contracts narrows [vs. widens]. Losses on bull spread trades are limited to the cost of carry (adjusted for convenience yield) assuming the market is efficient and no arbitrage opportunities are available.
• Bear spread. This strategy takes a short futures position in a short-term contract and a long position in a longer-term contract. In contangoed (backwardated) markets, the trade is profitable if the spread between the contracts widens (narrows). Losses on bear spread trades are potentially unlimited because the short-term contract can theoretically rise infinitely.

Question 25

**processing spreads**

Answer 25

* refers to the price difference between futures on a commodity and futures on the products derived from processing that commodity. * 2 common processing spreads: 1. **Crack Spreads** - Involves futures on crude, gasoline, and heating oil. Oil refineries use the crack spread to lock in profits. 1. The spread is generally expressed as a ratio X:Y:Z, representing the number of barrels of oil (X) INPUT, gasoline (Y) OUTPUT, and heating oil (Z) OUTPUT 2. the total crack spread profit is the difference between the initial crack spread and the crack spread at maturity. 3. Futures contracts on prespecified crack spreads are publicly traded, which allows refiners to easily use this as a hedge. 2. **Crush Spreads -** Involves futures on soybeans, soybean meal, and soybean oil 1. During processing, one bushel of soybeans is crushed resulting in one unit of soybean meal and one unit of soybean oil. As a result, commodity traders often use the spread between these three commodities in an attempt to extract arbitrage profits. 2. A crush spread involves shorting soybean meal futures and soybean oil futures and going long the soybean futures.

Question 26

Substitution spreads

Answer 26

* refers to a spread trade between two products that are correlated due to their ability to be substituted for each other. * Producers may be able to substitute one output for another using the same equipment, and consumers may be able to substitute one commodity for another. Producer substitutes include corn versus soybeans and heating oil versus jet fuel or gasoline. Consumer substitutes include natural gas versus oil-based fuel and cattle versus hogs * Due to their reliance on correlations (which may not continue), substitution spreads are riskier than calendar and processing spreads.

Question 27

**Quality spreads**

Answer 27

refers to a spread trade between different classes (i.e., degrees of quality) of the same commodity (e.g., jet fuel, diesel fuel, heating oil). * relatively low price risk , used by traders to provide liquidity to producers. * Most quality trades are conducted OTC, although spring wheat vs. hard red witner wheat can be exectued via futures.

Question 28

Location Spread (Commodities)

Answer 28

involves long & short positions of hte same commodity, but with different delivery locations in each contract. * mostly carried out OTC * trades that involve different delivery months and different locations are **arbitrage trades**. * sptread trades with the same delivery month but different locations are **correlation trades** *

Question 29

**Intramarket relative value strategies** (commodites) and 2 key strategies in this class

Answer 29

involve the use of commodity derivatives (e.g., futures, forwards, options, swaps) in conjunction with trading the underlying physical commodity. Generally used to hedge commodity position. 2 key strategies: 1. **Storage Strategies -** These strategies typically involve purchasing and storing physical commodities at a leased facility for future delivery, while simultaneously hedging the price risk through futures or OTC forward contracts. *Similar to futures calendar spread, but more labor and capital to execute* 2. **Transportation Strategies -** These strategies use leased transportation facilities (e.g., tankers, pipelines) to physically take possession of a commodity in a market where there is a surplus, and then transport the commodity to a market where there is a shortage. *carry additional risks, such as transportation risk, countryparty risk, and headline risk*

Question 30

LO 23.6: Demonstrate knowledge of capital structure and commodity-based corporations.

Answer 30

* Describe how equity and debt of commodity-based firms tend to act as hybrid investments. * Discuss the commodity risk management strategies of commodity producers. * Describe the effect of commodity prices on the risk associated with investing in securities issued by commodity-based firms. * Discuss commodity-based equity and debt investment strategies.

Question 31

Commodity based Corporations Value proposition (2 parts)

Answer 31

Sum of: * **Commodity rights.** Represent the value of commodity resources that have yet to be extracted. * **Enterprise value**. Represents the residual value of the firm’s assets, which equals the firm’s common equity plus debt and preferred stock minus cash, and other non-operating asset Consdiered *hybrid instrucment,* as beta reflects charactersitics of firm, in addition to commodity exposure risk.

Question 32

**Selective Hedging (**for commodities)

Answer 32

considered a direct hedge, used to add value by reducing risk through timing based forecast of commodity's price. *hedge when forecast predicts unfavorable price movement.*

Question 33

**Operational Hedging** (for Commodities)

Answer 33

add value and may reduce risk by altering the firm’s physical activities in response to a change in price of the commodity to reduce the impact on the firm’s profitability. The firm could make adjustments in the form of input quality, location, timing, and the use of real options.

Question 34

**Operational Diversification (**for Commodities)

Answer 34

refers to a commodity-based firm being structured in a manner that reduces its commodity risk. Operational diversification activities include utilizing multiple commodities, multiple commodity grades, and multiple locations. A highly vertically integrated firm tends to have much less commodity risk exposure due to its more balanced long and short commodity price exposures resulting in lower earnings volatility.

Question 35

**Upstream Commodity Producers**

Answer 35

Direct producers of commodities such as farmers or firms extracting commodities out of the ground

Question 36

**Downstream Commodity Producers**

Answer 36

firms that process the commodity into a marketable product.